Tuesday, 6 October 2009

Trading oil in Dollars - who cares...

This story, sometimes appearing in different guises, always gets tongues wagging. The end of the Dollar, the decline of the US. This is BIG news.

No it isn't.

When we want buy something from someone else we need some way to put a price on it. We could say, for example "this car will cost you 50 goats". No reason why we couldn't. The most astute readers will spot some potential problems with such an arrangement; for those buyers who don't own a herd of goats it will be difficult to properly assess exactly how much of your wealth such a purchase will require. How much other stuff, like housing, food, holidays etc. today and in the future will you have to forgo in order to buy this new car?

Follow this up with a couple of questions. Does the simple act of stating the price of the car in goats mean that:

  1. The seller will takes goats and nothing else in payment?
  2. If you don't currently have any goats you won't be able to buy the car, or it might cost you more than if you did have 50 of the critters munching on your front lawn?
  3. The seller is strictly demanding goats in payment (#1) so that they can be added to the ever growing flock in the paddock around the back of the car dealership?

Are we going to get any arguments if I suggest the answers to those questions are:

  1. No,
  2. No and
  3. No?


So what's the fuss about oil (or any commodity for that matter) and Dollars, or Yen, or Euros? We price stuff using some historical convention because it is convenient and communicates a lot of information to the largest number of people. Trading a global commodity sold and bought by everyone around the world is far easier when we talk the same financial language and the US Dollar has been the lingua franca of the industrial age. I can immediately compare the price of oil being sold out of Venezuela with the price of oil being sold out of Kuwait, make any adjustments I need to for differences in composition or quality and transport and know where the best deal is. That is why we use a single currency as a numeraire - which is nothing more than an accepted unit of measure. Sure, goats might make a better numeraire for a Tibetan goatherd, but the world has just naturally come to use Dollars.

But of course I am missing the point aren't I. There will be no need for Dollars any more. People won't want them. Really? Did you think about the questions I posed earlier? Saudis, Venezuelans, Iranians don't sit around thinking "damn, what can I do with all these Dollars I am getting?". They either buy US Dollar assets with them (anything from US government bonds, to real estate or equities or simply cash stuffed under the Persian rug), or they sell them to someone else so they can buy Euro government bonds, Chinese real estate or whatever.

Take the buy side. People aren't sitting on piles of US Dollars simply to buy oil. They trade what ever currency they hold to buy US Dollars (assuming that settlement is in fact in Dollars and not some other currency).

But what about currency risk you ask? If that is of concern, you hedge the currency. Changing the numeraire won't alter the economic implications of exchange rate movements. A 20% appreciation of the US Dollar (with oil price in Dollars) will bring the same affects as a 20% depreciation in the Euro (with oil priced in Euros). In both cases oil will become more expensive for some, in this example Eurozone buyers, relative to others, US buyers.

So, any change to a new numeraire for oil will not bring any earth shattering implications for the global economy. Nor will it happen at the whim of a group of people who think it matters and will try and enforce such a shift - those efforts will fail if buyers and sellers don't find it convenient. It won't be some catalyst to a dumping of US Dollar assets - this would have been done already if people didn't like US Dollar assets.

What it might do is:

  • Reduce the trade in US Dollar foreign exchange markets a little. But hardly to the extent that it would have any implications for spreads or liquidity
  • Reduce the seinorage that the US enjoys. This is the interest free loan that the US gets when someone holds some of their currency. This isn't a lot in the scheme of things at the moment and for reasons discussed above, changing the numeraire for oil trading is unlikely to dramatically reduce foreign holdings of US currency.

No. This story is just another round of penis comparison geopolitics. I fully expect that one day the Reminbi is very likely to become the global financial and trade numeraire. Nobody will need to legislate it, it will just happen over time. It will make nobody worse off and nobody better off, but simply change the language in which we talk numbers.

UPDATE: Just goes to show how poorly this blog is read. I have amended the incorrect reference to "Yen".

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